Why It Is Risky To Try To Profit From Bear Market Rallies

Summary

Some investors may be tempted to profit from bear market rallies.

However, in this way, they run the risk of missing the forest for the trees.

The article discusses the risks of this strategy.

S&P (NYSEARCA:SPY) has traded in a very narrow range, between 1800 and 2130, during the last 2 years. In addition, it has not posted a new all-time high for more than a year while the corporate earnings have decreased during the last four quarters. Therefore, it should not be surprising that there is an increasing number of SA authors who are calling for the next bear market. While I have repeated my view that a major secular bull market started 7 years ago, it has become very likely that a cyclical bear market may show up this or next year, before the secular bull continues. Therefore, investors should shape their strategies for a possible upcoming bear market, as it is much more efficient to have the strategy ready rather than form it in the thick of the battle.

This week I read an excellent article from an exceptional SA author, who summarized the patterns of previous bear markets and analyzed how investors could profit even in a bear market. I found the article particularly interesting and I believe SA readers have much to learn by following this author. Nevertheless, I disagree on one recommendation of the author; he suggested that investors can greatly profit during bear markets by identifying bear market rallies and timing properly their entry and exit points. In this article, I will analyze why investors should not attempt to profit from bear market rallies.

As history has taught us, bear market rallies usually do not get overextended, i.e., they provide limited returns from bottom to top, typically not more than 10% (see the chart below for example). Therefore, as no one can call the exact bottom or top consistently, even the investors who have exceptional timing skills will miss about 2%-3% from the bottom and a similar amount from the top. Consequently, if one adds the commissions and fees into the picture, one safely concludes that only a tiny portion of the move of a bear market rally can be captured as a profit.

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When estimating the cost of timing the market, investors should also keep in mind that those who remain on the sidelines miss the dividends distributed. If a portfolio includes stocks with solid fundamentals, those stocks will almost certainly maintain or even raise their dividend even during a bear market. To be sure, most stalwarts, such as McDonald's (NYSE:MCD), Wal-Mart (NYSE:WMT), Coca-Cola (NYSE:KO) and General Mills (NYSE:GIS), raised their dividend by about 10% during the Great Recession. Therefore, those who remained on the sidelines for a better entry point during that fierce bear market missed a significant amount of dividends.

Even worse, the total decrease of these stalwarts was much shallower than that of the broad market and hence there was a much narrower window for market timers, who were thus running the risk of missing the train in the subsequent rebound. For while it seems relatively easy to close positions during a fierce bear market and wait for a better entry point, it is much harder to identify the right moment to repurchase these positions. This is the case because the market strongly rebounds much earlier than it is evident that the storm has passed. Therefore, the risk of missing the train in the strong rebound is particularly high.

Finally, let's assume that a trader with exceptional timing skills identified the exact bottom in the bear market 2007-2009, was sitting at an approximate 10% profit and sold his positions, as bear market rallies typically do not offer much higher returns. While that 10% profit in a short period is a remarkable return, the great trader missed the remaining 190% of that major rally. In other words, there is no guarantee that a bear market rally will not morph into a major bull market. Instead history has taught us that it is a certainty that a major bull market will arise after a few failed attempts (bear market rallies). There is no alarm bell when this happens and the profit from a bear market rally is a drop in the ocean compared to the profit from a major bull market. Therefore, investors who try to time a bear market rally essentially miss the forest for the trees.

Despite all the above factors, some traders will still claim that they use some sophisticated technical indicators, which help them identify when the market is oversold and hence it is poised for a short-term rebound. Unfortunately for these traders, while the oversold-overbought indicators work perfectly in a range-bound market, just like the one we have been witnessing in the last two years, they do not work in a strong bear or bull market. More specifically, the market can become extremely oversold in a bear market and extremely overbought in a bull market. Therefore, these indicators are worthless when there is a strong trend in the market.

To sum up, by looking at historical charts, investors may erroneously think that it is easy and sometimes fun to time the market and make some extra profits, which will help them beat the market. Unfortunately, it is always easy in retrospect but much harder in the thick of the battle. What usually happens is that market timers make some nice, small profits in the beginning but then they miss the major move. Therefore, I advise investors to avoid the temptation of timing bear market rallies. Instead they should focus on purchasing stocks with great growth prospects and minimum debt at bargain valuations and keep these stocks at least until they reach full valuation. Only this strategy will enable them to achieve great returns in the long term.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.